I hadn't realized until I read Jane Galt that the Hawaii gas price controls are on the wholesale price of gas, not the retail price. That is really shocking, because economic theory would suggest that prices are set by supply and demand, not simply cost.

If the wholesale cap is set above the market price, then the caps should have no effect whatsoever.

If the wholesale caps are set below the wholesale market price, the one thing that won't happen is that more gas will be supplied than if the wholesale prices were higher. If somehow supply were unchanged, theoretically there should be almost no difference in retail prices; the gas station owners should pocket the difference. As Galt points out, there may be some political pressure to lower prices a bit, so it is not impossible that prices would fall some, but there is no strictly economic reason for this, absent fear by gas station owners of more government regulation and interference with profits.

Yet standard economic theory would suggest that, if wholesale prices are set below market wholesale prices, the supply would fall. If there is any excess refining capacity anywhere else, the gas refiners would rationally move the gas to those other refineries, since they could get the full market wholesale price elsewhere. We would expect to see shortages, leading to higher retail prices in Hawaii, not lower ones. If supply drops and somehow retail prices stay the same, one would expect to see gas lines and rationing.

The entire proposal is based on the economic system having relatively high transaction costs of moving sales or production elsewhere. Without transaction costs, there would be little reason to sell gas in Hawaii for $2.16 if the same gas could be costlessly sold instead for $2.20 elsewhere.

The law, set to take effect Sept. 1, ties the price of gas to the wholesale price of gasoline at three price points on the U.S. mainland.

Charged with the unenviable job of implementing the gas-cap program, Hawaii's Public Utilities Commission says local industry expects the caps to increase prices by an estimated 30 cents a gallon, with costs on Oahu rising from the current price of $2.68 a gallon to more than $3. PUC says industry leaders also expect more shortages (especially in remote areas), the closure of one of two oil refineries, the halting of wholesale marketers' operations, and reduced investment in the state after the caps go into effect. Owners of gas stations on remote neighboring islands say prices will likely soar after Sept. 1, from just over $3 a gallon to more than $4.

"We will continue to do business as usual until such time as the situation requires us to do something different," said Albert Chee, a Chevron spokesman in Hawaii.

"Having said that, we continue to believe the law is flawed and is not in the best interests of the state. We continue to be concerned about the potential for adverse, unintended consequences."

Tesoro, meanwhile, said it had "ample supply" in Hawaii distribution and that its local refinery was operating at full capacity, indicating it didn't expect to run low on gas in Hawaii.

This is a nice test of economic theory, though if refineries are working at nearly full capacity, the economic effects may not be as large in the short run as simple price theory (in the absence of transaction costs) would suggest.

UPDATE: If you are interested in more sophisticated analyses (including relaxing my assumption that the actual amount of gas supplied would not rise with caps), you should read the comments below.

2D UPDATE: Brian at Backseat Driving argues in opposition that the analysis I recount "fails to consider whether a standard market exists for wholesale gas, just noting without comment that there are 2 refineries and 6 wholesalers, which is nothing like a standard market. Standard monopoly theory, on the other hands, says the wholesalers could be price-gouging retailers, and caps that limit the gouging will not limit the overall gas supply."

It's a particularly dumfuk experiment precisely because it will be very difficult, politically speaking, to back out of it when it doesn't work.

Assume ex hypothesi the cap is below the market wholesale price (there being no point to it otherwise), and that the obvious thing happens, which is that wholesalers sell the stuff elsewhere, a shortage develops, and retail prices climb steeply.

Now what? Go to the citizenry and say, folks, clearly we've got to do something about these soaring gas prices, so I propose we remove the cap on the wholesale price of gas? Ha ha. That'd be a right quick route to retirement for any politician.

Let us assume, for the sake of this post, that you're correct that the effect of a cap on wholesale prices can be treated as a simple fixed-amount reduction in the supply of gas provided by the refineries. (This might be a very tenuous assumption. In theory, the market wholesale price was such that the providers of crude oil were indifferent between sending it to Hawaii or any other state, and if a ceiling were placed on wholesale prices, they should divert *all* of the crude to a different state to earn more profit. But Hawaii's claim that transaction costs will limit this redirection is a very interesting argument, even if I'm skeptical.)

I'm not so sure your analysis is correct, because it fails to account for competition between gas stations. If there's perfect competition between stations, then "standard economic theory" would expect each station to sell the gas at the price that it costs them (on the margin) to provide it (= the wholesale price + some overhead for employee wages, utilities, and other costs of running the station). If this were the case, then a decrease in wholesale price will translate into a *decrease* in the price at the pump.

In fact, you could reach the same conclusion even in a model without perfect competition. Consider a Bertrand Oligopoly model, where there are a finite number of firms (as few as two) that compete by choosing prices. Suppose that it costs $2/gallon to supply the gas, and suppose we have two stations, A and B, which each begin by charging $2.50/gallon. Station A realizes that, by lowering its price to, say, $2.45/gallon, it could steal away B's business and increase its profit. In turn, Station B would lower its price to, say, $2.40/gallon. Repeat until A and B each lower their prices to $2/gallon. The result demonstrates a very interesting implication of the Bertrand Oligopoly model: even if you have as few as two firms, and even if the total supply is very limited, if the firms compete by choosing prices then the price will fall until it equals the (marginal) cost of supplying the good.

Of course, if the gas stations were very smart, there *are* ways in which they could capitalize on the limited supply to earn some extra profit. Ideally they'd like to collude, but even if they could enfore a stable cartel, this would violate antitrust laws. But if we had *really* smart gas stations where the owners knew a little game theory, they could increase their profits.

Consider a different oligopoly model, the Cournot Oligopoly, where rather than competing by choosing prices (as was the case in the Bertrand Oligopoly), the firms compete by each limiting the quantity of gas that they're willing to sell. Suppose we have N firms, each of which has the same marginal cost c. Suppose we know demand as a function of price, Q(p). Since the stations in this model will be setting q, what we're actually interested in is the inverse demand function, P(q) (so at quantity q, P(q) is the market-clearing price). Now let me introduce the notation q* to represent the total quantity available, q_i to represent the quantity sold by a representative station, i, and q_-i to represent the total quantity sold by all stations but i. (So q_i+q_-i=q and N*q_i=q*.)

The station chooses its quantity, q_i to maximize profits,
max{q_i} P(q_i+q_-i) - c*q_i.

This is solved by the first order condition
P'(q_i+q_-i)*q_i + P(q_i+q_-i) = c

(As an aside, without going into details, it could be shown that this corresponds to a fractional price markup of (P-c)/P = 1/(N*e), where e is the price elasticity of demand.)

Now we get to the interesting implication of the Cournot Oligopoly model. Add up all N firms and we find:
q* = N[c-P(q*)]/P'(q*)
We can rewrite this as
P'(q*)*q* + N*P(q*) = N*c
or
(1/N)*MR(q*) + [(N-1)/N]*P(q*) = c
where MR is marginal revenue. If N=1, this reduces to the same quantity and price of a monopoly (such that marginal revenue equals marginal cost). As N approachs infinity, this reduces to the same quanity and price as perfect competition (price equals marginal cost). For anything in between, then the Cournot model suggests that if you have smart firms that all know to limit their quantity, then you'll have a markup that decreases as competition increases.

So, which is it -- do prices fall to marginal costs, or do the stations succeed in adding a markup that will increase as the total supply decreases? Allow me to make four observations:

1. If gas stations really competed as Cournot Oligopolists, they would *already* have been doing so *before* Hawaii instituted the price caps. Even if you didn't have the refineries limiting the total supply, the stations themselves would (implicitly, by all using game theory) agree to limit the supply. So if the Cournot Oligopoly model were true, we would expect to see no change in prices!

2. I don't imagine that too many gas station owners are well-versed in game theory. Nor do I think that gas stations think in terms of setting a target quantity of gas sold, as the Cournot model would require, but rather I suspect they focus entirely on prices, as in the Bertrand model.

3. If even a single station begins to compete in price and is able to undercut the other stations to increase its own profit, the Betrand Oligopoly model should quickly take over and drive prices down to marginal costs.

4. But *can* a single station continue undercutting all the others? Here's the catch. A station can only keep reducing its prices until it sells all of its gas and runs out. Now that the refineries would be limiting the total amount of gas they provide at the (now-capped) wholesale prices, their limits might be the very thing that prevents one station from undercutting the others, preventing the Bertrand model from taking hold. In fact, even if the gas stations weren't smart enough to all limit their sales to q_i, the refineries could effectively force them to by refusing to provide any one station with more than q_i gallons of gasoline. This would be very interesting!

This brings us to a very important question that can't be solved by any economic model: with the refineries facing wholesale price caps, how will they decide to distribute their limited supply? Previously, if their supply was less than the stations' demand, they would simply increase wholesale prices and continue selling to any station that wanted, letting the market allocate the supply of gas. But now they're going to need to resort to some non-price mechanism for allocating their supply. Will it be first come, first served? That doesn't make a great deal of sense. Will it be divided up evenly among all gas stations that want it? That, interestingly, would lead to a situation resembling Cournot Oligopoly, but I'm not sure if this is a likely distribution method, either. If it's something else, will this allow one station to keep buying up a greater and greater portion and thus allow it to undercut the other stations, as in the Bertrand Oligopoly model?

I suppose that the best thing for the refineries to do in this situation is to try and encourage a Cournot oligopoly. They're being hurt by these caps, so they in turn should do as much as possible to make the state hurt and the caps backfire until they're repealed. But I'm not sure if the refineries will really think the situation through in this manner; it might be giving them too much credit.

Ultimately, I don't think this works out to be the "nice test of economic theory" that you suggested. As we've seen, even the economic theory is conflicted about whether the stations will follow the Bertrand model (where gas station prices fall with the wholesale prices) or the Cournot model (where prices either are unchanged or rise). And as I noted at the start of this comment, the very premise that we're working on -- that transaction costs of moving sales or production elsewhere will be so great that oil producers don't just stop sending crude to Hawaii altogther -- is a novel claim that might itself contradict simple economic theory.

Eventually, something will have to change as a result of these caps and have an adverse effect on Hawaiians. You can't just mandate that prices be decreased and have everything else stay the same; there's no such thing as a free lunch. But I'm not certain you can rule out that the immediate, very short-term effect will be to decrease gas prices. Time will tell, I suppose.

Scott: I'd be lying if I pretended to understand half of your last post, but do your equations take into account the fact that gas stations are generally prevented from undercutting eachother on price? I'm not sure if it's a state-by-state thing or federal, but here in Wisconsin gas stations are only allowed to alter their prices once a day, and they can't change the price by more than X cents, and so on. I think these restrictive laws would render your "bertrand oligopoly" model impossible.

"If there's perfect competition between stations, then "standard economic theory" would expect each station to sell the gas at the price that it costs them [more or less]. If this were the case, then a decrease in wholesale price will translate into a *decrease* in the price at the pump."

I don't think this is true. If we expect to see a drop in supply at the wholesale level, we expect to see a drop in supply at the retail level. If there is a drop in supply at the retail level to the point where there is a shortage at a given price, sellers have the ability to raise their prices to the point where retail demand and supply come out at equilibrium. (e.g. each one would say "I don't care if the next guy sells much cheaper than me today, because I know if he sells it too cheap, he'll be out tomorrow, and people will then be willing to pay my price.)

That seems to be the crux: If the supply produced by the refiner at the price cap level is sufficient to supply the consumers, retail prices should continue to be low. If the cap is too low, retail prices have the capacity to rise.

Scott, I appreciate someone with your superior economic expertise commenting, but I think there is a problem. As Tom indicates, if supply is limited, a gas station owner would say, "I don't care if the next guy sells much cheaper than me today, because I know if he sells it too cheap, he'll be out tomorrow, and people will then be willing to pay my price."

I explicitly assumed that the current supply would not rise with caps. As I understand your presentation of the Bertrand Oligopoly model, a gas station owner with lower costs would be happy to sell his gas for 5 cents less if he could buy more gas to sell to his customers. But, as Tom indicates, if he can't sell more gas at 5 cents less, then he wouldn't lower his price at all.

So it all comes down to supply. Can gas stations in Hawaii get more gas if they could profitably sell more of it at 5 cents less? If so, then the Bertrand Model may well work. But if stations can't get more gas, then Tom's analysis is correct.

I assumed explicitly: "If the wholesale caps are set below the wholesale market price, the one thing that won't happen is that more gas will be supplied than if the wholesale prices were higher."

This seems right, but I can see that it begs a slightly different question: just how tight are the supplies in Hawaii now? If supplies in Hawaii are not particularly tight (and price-cutting stations can buy a lot more wholesale gas), then Scott's Bertrand Oligopoly alternative analysis might take hold and lower prices.

If supplies are very tight already (or are made very tight by the cap), then prices should not drop and may rise because if all the gas that an owner can get for $2.16 can be sold for $2.80, why lower your price to $2.75?

We're talking about Chevron and Tesoro, both national refiners. They will eat their Hawaiian problems rather than divert 100% of their (all imported, remember) feedstocks back to the mainland (Scott's right about that, theoretically). That would make their P.R. problem a national one (New York Times, etc.).

Betrand oligopoly requires that each seller be able to sell whatever quantity it can sell at a given price. An effective wholesale price ceiling will, by definition, restrict the quantity supplied to a level below the market clearing quantity. Gas station owners will not be able to choose the price and sell whatever quantity results, instead they will have access to a limited quantity, less than what they would have bought in a free market, and then the choice will be to set a price to maximize their profits, i.e. Cournot competition.

If, for whatever reason, the gas stations sell at marginal cost, then there will be shortages. At the prevailing price consumers will be willing to buy more gasoline than gas stations have to sell.

If station owners raise there prices to the profit maximizing level then average prices will increase. If the legislature freezes retail prices, expect shortages, i.e. long lines and bizarre rationing schemes. If the legislature merely caps the increase in retail prices below the market clearing level we can expect higher prices and shortages.

Remember, you heard it here first: I postulate the "Tchotchke Economy." As everyone else has detailed out, the oil shippers will stop shipping crude to Hawaii. This will happen quickly, as ships in the area will simply divert to Japan, China, Korea, etc. Retail prices will soar to ration the supply. Station owners, desperate to get some gas to sell at these heady prices, will find a way to compensate refiners under the table.

That's where the tchotchkes come in. Every station, even without a convenience store attached, has a few things for sale inside. So the gas wholesalers go out and and acquire some cheap tchotchkes, which they will sell to the station owners at grossly inflated prices. The money exactly makes up for the lowered wholesale price of the gasoline, the refineries open back up, the crude oil comes back in, supplies are restored to previous levels, prices go to pretty much where they would have been. They will be a little higher to make up for the inefficiencies of the tchotchke sham transactions, but not so much that the politicians will take a lot of blame.

I like looking at supply and demand graphs. Above is supposed to be a drawing of a supply and demand graph, where p and q are the market clearing price of gas. People familiar with supply and demand graphs should be able to recognize the features. p1 is the capped price of gas, which will elicit a supply of q1. p2 is the market clearing price of q2 gallons of gasoline. p2 will be the retail price of gas.

If the definition of "wholesale gas supply" remains the same, in the long run retailers will spend p2-p1 to get access to the gasoline from which they purchase from wholesalers at the p1 price, just as rent-seekers dissipate the entire value of the rent they are seeking in the effort to win the rent. There is no extra profit in it for the retailers, just a change in the composition of their costs.

Personally I would first expect the definition of "wholesale
gas supply" to change in ways that shifts the supply and demand curves around to make p2 the new market clearing price.

I don't know much about the details of the wholesale gasoline industry, but almost every sales relationship includes anciliary services provided by one party or another. For instance, at one time the grocery sales relationship included the grocery going into the stockroom to pick out items from the shelves. That service has long ago been replaced by customers doing effectively the same thing.

I suspect that there are some aspects of the wholesale gasoline sales relationship that can be altered to shift non-controlled costs from the supplier to the purchaser. I hope so, anyway, as that would probably least supply problems and the smallest retail gas price increase.

Does it sound familar? Of course it does. It is California all over again trying to do the same thing with electricity the same way. Bottom line, only a free market can allocate resources efficiently. Governement never can.

This discussion of alleged economic theory misses an important point--retail prices at each gas station are almost completely determined by wholesale prices. To put it more directly, retail margin is nearly fixed--individual variations in local prices can be attributed almost entirely to daily wholesale fluctuations and expiration dates of individual contracts. In fact, with rizing prices, it is the retailers who have been squeezed by being forced to reduce margins. With fixed or shrinking margins, your whole economic theory goes out the window. If you want a real test, take a look at Enron's manipulation of the California energy market.

I saw mention elsewhere that a significant portion of Hawaii's refinery output is non-gasoline, particularly aviation fuel, presumably for the Navy as well as the commercial air carriers. Do the price caps apply to products other than gasoline? Can the refiners easily change their relative output to continue crude oil purchases at their current levels while directing more of their production from regulated to unregulated output?

Let me try to highlight the key points I was seeking to make earlier, as I think most of the responses can be tied into them quite nicely:

1. The initial analysis -- which I took to be arguing that (1) a ceiling on wholesale prices will reduce the total supply provided by refineries, and (2) a reduction to the supply that reaches consumers means an increase in prices faced by consumers -- was incomplete because it neglected the intermediate stage. It would certainly seem correct if there was only a single middleman between the wholesalers and consumers, with prices unaffected by competitive pressures; that one entity, having market power, would be able to set the price at the profit maximizing level, keeping most of the surplus. But we actually have a number of different gas stations, and there may be competition between the stations. If there's sufficient competition, you might find stations lowering their prices, reducing the total surplus/profits going to the gas stations (the rest of the value goes to the consumers), in order to try and claim a bigger portion of those total profits for itself. If there's sufficient competition, the competitive pressures can force prices down until stations don't charge any markup above wholesale.

In effect, Jim laid out one possible scenario - it's possible that if wholesale supplies are reduced, gas stations will react by raising the prices in order to maximize their profits - but it's also possible that competitive pressures will force them to forego any profits. (The neat thing about competition (in theory) is that it forces firms to "give up" their chance to earn profits. The reason they do so isn't because they want to give consumers the best possible deal, but that's a nice side-effect!) If competition is sufficient to reduce markup to zero (as Buck Turgidson alleges is the case, but I'd want empirical data to back that up), then a reduction in wholesale prices - if successful (but see below) - would lead to a reduction in prices at the pump.

2. So we have a possible worst-case scenario where stations raise prices to maximize profits, which Jim laid out initially, but we also have a possible best-case scenario where competition causes them, in effect, to voluntarily forego any profits and decrease their prices to match wholesale prices. The question, then, is how competitive the market is at the retail (gas station) level.

It looks like I might've been unclear on this earlier. I didn't mean to say "competition does exist, so prices will fall" - rather, I meant to say that IF enough competition exists, they'll fall. Toward the end of my earlier comment I was a bit skeptical of this (see point #4 in that comment) -- the limited supply from the retailers might even *reduce* competition, either because (as Tom suggests) station owners might think it's less likely that another station can continue undercutting them in the long run, so they don't lower their prices in response and no price war ensues; or (as Jim points out) a station that wants to undercut others might be unable to do so because they don't have enough supply; or (as I pointed out earlier) if each station is given a fixed supply of gas and maximizes profits on its own, without regard to competition, it will be acting just as it would if it were part of a Cournot Oligopoly.

3. So, how much competiton *will* there be? Economic theory won't give us an answer on this one. Let me reframe the question: suppose that we had one station which wanted to undercut the others; will it be able to do so? That depends on how the refineries distribute their supply. The station can go to the refineries and ask for a greater portion of the supply; if the refineries agree, then this station can undercut the others, but if the refineries refuse, the station cannot.

And economic theory can't tell us a thing about how the refineries will act. Normally, it would tell us that the refineries will give their supply to the highest bidder, but no station can offer to pay more than the price cap that Hawaii has instituted! So what do they do when a station comes asking for a greater portion of the supply? Maybe they do first come, first served. Maybe they give each station an equal portion. Maybe there are off-the-record side payments (bribes, really). Maybe you'll see the "tchotchke sham transactions" that Cathy suggests (in fact, this would be a smart way to go!). We just don't know what will happen here. It all depends on how the refineries decide to distribute their supply, but the refineries don't really have any reason to favor one method over any others; it's a strange situation.

4. In any case, it's the wholesalers whose incentives are most affected by the caps, and I think we should be focusing on them. I don't think it's right to use the supply-demand framework here, because that assumes that the refinery has market power -- that is, it assumes that if the refinery changed its demand, the price that its suppliers charge for crude oil would change. But in the grand scheme of things, the Hawaii refineries are a small part of the crude oil market. They're much more likely to be price-takers -- that is, the crude oil suppliers tell the refineries that the price of crude oil is $2/gallon, and the refineries can take it or leave it.

If the refineries are price-takers, then our whole starting point is wrong. The correct analysis would be to compare the price caps to the price of crude oil. If the capped price is still greater than the price of crude oil, and the refineries are still profiting, then the refineries will still supply plenty of gas. (What would it mean if this were the case? It would mean that the refineries were previously charging more than the competitive price, indicating a market failure, the government intervention could successfully lower the price.) If the capped price is less than the price of crude oil, then the refineries will simply stop producing, since they're bound to lose money. I fear we might see something along these lines, which would be disasterous.

being a long time resident of the island of oahu. I can only tell you that this plan was concieved of several years when the price gap between Hawaii Gas Prices and Mainland Gas prices were large. The state sued cheveron for fixing prices and our then democrat governor settled out of court, and the game continued. Now that prices on the mainland have risen, The price gap is nonexistent (for some odd reason). This is why the gas cap will fail...
Simply do to the fact that the market has already restored hawaii to a place the is reasonable in the gas price spectrum.

now that the first cap is set @ $2.16 + TAX = $2.76 /gallon

This is before retail markup..
This is GOING TO RAISE OUR PRICES
why would a company not charge the maximum they are allowed. The government is telling them they can charge more than they currently do so why not go ahead and do it.
Now with the natural disaster that may not affect us since we do not recieve any refiened gas from the gulf coast in this state (we refine our own and import refined from the west coast) our prices will go up!

My firm was retained to look at the issue for the Cayetano administration. You can find our work at www.stillwaterassociates.com/gascaps.

We expect that suppliers will price at the caps. Now that the rules and actual prices have been published, it is clear that the caps will lead to hoarding, shortages, gas lines, and other problems. For example, the price on Monday, Sept 5 will be capped at 27 cpg over the Sept 1 price. Consumers will want to fill up by Sunday because they know the price will go up. This may create lines and spot run outs at stations, even though there is plenty of gasoline in Hawaii and the refineries are running ok.

Further, we are concerned about hoarding. In Los Angeles in 1979, during the last price control period, people filled plastic trash cans in their apartment closets with gasoline. Many of those places burned down. Gasoline can be very dangerous if improperly handled.

In an extreme example, a profit seeking retailer could fill up his station tomorrow and shut down until Monday, when the price goes up 27 cents.

These actions will strain a distribution system that is designed to run at a steady level. For example, the barge goes to Maui every week. If folks rush to fill up, stations will run out but the barge can't go any faster. Something very similar happened on Molokai a couple of weeks ago.